Chapter 2: Literature Review

2.1 Introduction

This chapter contains the related literature on corporate governance and risk management. This

chapter is divided into six major sections, second part of the chapter contains the theoretical

background wherein the existing theory provide grounds for the need of corporate governance.

While the third section of the chapter shows the relationship between corporate governance and

risk management in banking sectors, fourth part of this chapter shows the elements of corporate

governance and their relationship with risk management. Fifth part of the literature review shows

z-score and its relationship with risk management i.e. the empirical work conducted using z-

score as a proxy for risk management and the last part of the chapter shows the theoretical frame

work which is derived from the existing literature.

2.2 Theoretical Background

2.2.1 Agency theory and Corporate Governance

This theory states that the administration or the managers of the firms are not acting in the best

interest of the shareholders, rather they are interested in their own benefits. This theory further

states that the management cannot be given free hand as they are not in the eve of the

shareholders wealth maximization. Agency theory receive a major response because it was

considered as more reflective of the reality.

Corporate governance evolve with agency theory where the management of the firms must be

controlled to ensure that the management acts in the interest of the shareholders and they carried

out full compliance with the rules, policies and directions. These practices enhance agency costs
which according to this theory should be issued in such a way that the cost of reducing losses

incurred by noncompliance rises to the increment in authorization costs.

Agency cost consists the costs incurred to produce transparent financial reports, audit fees and

internal controls are also part of the agency costs.

Nevertheless, the potential for the emergence of agency problems persists because of the

separation between management and company ownership, especially in public companies.

Good governance is based on agency theory (Jensen and Meckling 1976).Consistent with agency

theory, the primary objective of the good governance is to manage managerial decisions.

A good corporate governance is the one which regulates and controls firms that maximize the

value of its shareholders (Monks, 2003).

Equity ownership structure is one of the indicators of good corporate governance system. Equity

ownership structure is consider a vital instrument to overcome the problems of corporate

governance system i.e. agency problems between shareholders and management. The structure

of equity helps in deciding the company’s decision making and incentive mechanism, which

affects the company behavior as well as business performance. The influence of

managerial ownership on firms’ value is related to the perspective that firms’ value depends

on the distribution of ownership between managers and other owners, first underlined by

the Berle and Means (1932) and Jensen and Meckling (1976). Within this contest and the so-

called ‘incentive argument’, giving managers corporate shares makes them behave like

shareholders. When the managers become owners, manager concentrate on the maximization of

the cash flow in order to gain an opportunity to expropriate the corporate fund in

producing profit on their own behalf. Berle and Means (1932) emphasize that potential

conflicts of interest arise between manager and dispersed shareholder, when manager do
not have an ownership interest in the firm. This statement support by Jensen and Meckling

(1976) that suggest that as managers own the firm more, the managers are less likely to

divert resources away from value maximization, as a result the firm performance is

predicted to increase with the managerial ownership.

2.3 Corporate governance and risk management in Banking Sector

The increasing complexity of risks faced by banks will create an increasing need for corporate

governance practices by banks. To enhance the efficiency of the bank, strengthening the

compliance and protecting stakeholders’ interest with regulations and ethical standards relevant

to the banking industry, good corporate governance is required. Within the hypothesis of GCG,

performing artists in government include the state government, open division and private

division (Fernandes and Fresly, 2017). Improving the standard of execution of corporate

governance is one of the initiatives pointed at moving forward the inside state of the keeping

money framework.

Execution of corporate administration standards is at the slightest realized in (1) execution of

obligations and duties of executives and board of commissioners; (2) completeness and

execution of obligations of committees and working units that perform internal control functions;

(3) implementation of compliance function, internal audit and external audit; (4)implementation

of risk management; (5) arrangement of stores to related parties and arrangement of significant

reserves; (6) a vital arrange; and (7) straightforwardness of money-related and nonfinancial

conditions.

Therefore, in a situation of a planned top-down strategies change in government, what is needed

is learning flow from the organization to the individuals (Limbaet al., 2019).Bank is required to

conduct its own assessment of its soundness using a risk-based bank rating (RBBR), both
individually and in consolidation, which includes, among others, the assessment of corporate

governance factors. GCG is one instrument to strengthen internal conditions of national banking.

Therefore GCG is a prerequisite for sustainability bank (Binhadi, 2007).

According to Tunggal (2013), GCG may be a framework that regulates, manages and supervises

commerce control forms to extend share esteem, as well as a form of attention to stakeholders,

employees and surrounding communities. Self-assessment of governance factors is an appraisal

of bank administration on the execution of administration standards.

Each rating factor is ranked according to a comprehensive and structured analysis framework.

The determination of governance ranking is undertaken based on a comprehensive and structured

analysis of the results of the assessment of the implementation of governance principles and

other information related to bank governance. Governance rankings are categorized into five

ratings, Ranks 1–5. The smaller GCG ranking rank order reflects better governance

implementation. Risk is a possible failure as a result of a specific event. Risk management is a

collection of methodologies and procedures used to define, calculate, track and regulate risks that

occur from all of a bank’s business activities. Risks that can expose banks include market risk,

credit risk, liquidity risk, compliance risk, operational risk, reputation risk, strategic risk and

legal risk.

Chen and Ling (2016)analyzed the part of corporate governance relation to credit risk, interest

rate risk and liquidity risk faced by banks. The results indicated that interest rate risk, liquidity

risk and credit risk are interrelated and that these interactions can be mitigated through corporate

governance and regulation. Mean while, De Andres and Vallelado (2008) measured corporate
governance mechanisms through the composition and size of the board of commissioners. The

part of the boards of commissioner relates to the ability of the boards of commissioner to oversee

and provide management advice, and the larger portion of independent commissioners proves to

be more efficient in monitoring and advising functions and creating more corporate value. Our

study attempts to examine the relationship between corporate governance and risk management

of Indonesian banks. Implementation of corporate governance was measured by governance

composite rating, which is the result for self-assessment by the bank. While bank risk

management was measured by four risks that can be measured quantitatively, that is, credit risk,

market risk, operational risk and liquidity risk.

The implementation of GCG for Commercial Banks is considered very important

because GCG is used as the implementation of high risk banking activities so that the

performance of banking activities should be based on consistency, transparency,

accountability, independence and equity and fairness

Further, Sloan (2001) argues that corporate disclosure is one of the corporate governance

mechanisms employed for the purposes of external management oversight. The above studies

have documented, consistent with their theoretical arguments, a relationship between

corporate governance and voluntary disclosure based on the latter’s role as a control mechanism

for agency problems. The effects of corporate governance on reporting practice mitigate

information asymmetry and improve the stewardship function. Accurate risk information,

as an external control mechanism that reduces agency costs, is fundamental for

shareholders, analysts and investors, enabling them to assess a company’s risk profile, estimate

its market value and make accurate investment decisions (Rajgopal, 1999; Jorion, 2002;

Kravet & Muslu, 2013; Miihkinen, 2013; Campbell et al., 2014).

2.4 Elements Of Corporate Governance and Risk Management

Empirical studies have revealed several corporate governance elements and their impact on risk

management have been witnessed. Some of them are discussed as under.

2.4.1 Board Size

The board monitors the management more effectively, the quality and regularity of the

information made known to the investors by the management does improve (Ajinkya,

Bhojraj, & Sengupta, 2005; Karamanou & Vafeas, 2005). Verrecchia (2001) demonstrates

that greater disclosure will lessen the need for research into private information. From this

argument, it would appear that information asymmetry, generally speaking, is not as high in

those firms that have more effective boards. It has been argued that board size is a key

element in determining the effectiveness of a board of directors.

On the one hand, Yermack (1996) argues that large boards are likely to be less effective than

smaller boards at reducing agency costs. On the other hand, in firms with a higher ownership

concentration, and where insider shareholders are strongly represented on the boards, larger

boards do not necessarily signal a less effective governance structure (Di Pietra, Grambovas,

Raonic, & Riccaboni, 2008). This literature supports the view that larger boards may be

more effective in reducing actual agency costs by aligning any conflicts of interest that

may occur between insiders and outsiders. Recent research has questioned the extent to

which larger boards can affect levels of disclosure (Di Pietra, Grambovas, Raonic, &

Riccaboni, 2008; Lynck, Netter, & Yang, 2008). Empirical research, mainly based on US

data, supports this view.

For instance, Hoitash, Hoitash, and Bedard (2009) examine the impact of board size on the

level of voluntary disclosure, and Yermack (1996) investigates the effect of board size on

firm value. In their analysis of the Alternative Investment Market (AIM) in the UK,

Mallin and Ow-Yong (2012) found voluntary disclosure to be positively related to board size.

In the Italian context, Allegrini and Greco (2013) obtained the same result. Lynck, Netter, and

Yang (2008) further maintain that insider shareholder representation on boards is more typical of

smaller and less independent boards, a finding that ties in with the theory that managerial

ownership and board monitoring can substitute for governing mechanisms.

2.4.2 Board Independence

Agency theory argues that independent directors are likely to mitigate agency conflicts

between insiders (managers) and outsiders (shareholders), as these directors will have no

ties with the managers or representative shareholders and should be able to offer truly objective

opinions that benefit the company (Patelli & Prencipe, 2007). Independent directors may also

have high incentives to increase the levels of voluntary disclosure and thus signal their lack of

complicity with the insiders (leaders, management and strong ownership) and their own ability to

improve their company’s market value.

Prior research (Ajinkya, Bhojraj, & Sengupta, 2005; Karamanou & Vafeas, 2005) has

examined in detail the influence of board structure on voluntary disclosure levels. These studies

find that board composition, measured by the percentage of independent directors on a

board, and the quality of the board of directors overall are likely to influence the amount of

corporate information managers can manage and disclose. These studies further argue for
a positive relationship between board composition and the level of corporate disclosure.

Early evidence provided by Forker (1992) and based on 82 UK listed firms found a positive link

between financial disclosure and the proportion of independent directors. Consistent with that

evidence, Donnelly and Mulcahy (2008) demonstrate that voluntary disclosure increases

with the number of non-executive directors on a board. Gul and Leung (2004) further find that

independent directors are likely to significantly increase firms’ abilities to exhibit more voluntary

information than other firms. More recently, Romano and Guerrini (2012) have found a positive

correlation between mandatory disclosure and independent directors in a sample of Italian listed

companies over the period 2002-2010.

2.4.3 CEO Duality

In mandatory terms and/or when offered voluntarily.CEO duality. CEO duality refers to the

situation in which there is no separation between decision control and decision management

(Fama & Jensen, 1983). It is argued that firms with CEO duality are likely to offer poorer

disclosure (Finkelstein & D’Aveni, 1994).Prior research on corporate governance offers mixed

results with regard to the association between CEO duality and disclosure. For instance, Cheng

and Courtenay’s (2006) results do not support a significant impact of CEO duality on voluntary

disclosure, while those of Li, Pike, and Haniffa (2008) do.Worrell, Nemec, and Davidson (1997)

provide evidence that the stock market tends to react negatively to announcements of CEO

duality, which would seem to support the claim that CEO duality has a negative effect on a

board’s monitoring role. Consistent with this point, Gul and Leung (2004) find that CEO

duality is likely to reduce the level of voluntary disclosure. Similarly, Cerbioni and Parbonetti

(2007) find evidence that a concentration of power is negatively associated with both the

quantity and the quality of the voluntary disclosure of intellectual capital. More recent
research within the Italian and UK contexts supports the negative impact of concentrating the

power of the chairman and CEO in one person on the voluntary disclosure of general or

forward-looking information (Allegrini & Greco, 2013; Wang & Hussainey, 2013).

2.4.4 Dividend Policy

According to agency theory, dividends may have a mitigating effect on agency costs through the

distribution of free cash flow that a firm’s management might otherwise spend on unprofitable

projects (Jensen, 1986). Fluck (1998) acknowledges that dividend policies are a way of dealing

with agency problems that relate to corporate insiders and shareholders. Dividend payments

may be viewed as a sort of risk premium that is distributed to the shareholders. In

addition, investors who receive dividends may have less interest in information concerning the

risks a firm is addressing. Thus, paying dividends may make up for reduced risk disclosure.

The empirical research (e.g., Mancinelli & Ozkan, 2006) shows that the payouts of Italian

companies are inversely proportionate to the voting rights of the largest company shareholder.

The fact that firms have a choice of dividend policy suggests that high dividend payments are

associated with less riskiness and less information asymmetry for firms. The higher are

the dividends, the better will be the corporate governance practices of the company, thus

reflecting the power of the minority shareholders.

2.4.5 Concentrated Ownership Structure

The fact that ownership and control are separate in private and public corporations leads to a

problem between principal and agent, which can result in a less than optimal use of capital

(Shleifer & Vishny, 1997). Wherever ownership is widely dispersed, the individual

shareholders have practically no incentive to monitor the management. The marginal cost of
such monitoring is often greater than the marginal benefit of the better performance that

may result from it. Concentrated ownership may bring about better management control since the

volume of the ownership stake and the incentive to monitor are positively linked. Better

management controls likely to improve firm performance and, thus, provide benefits to the

minority shareholders. However, there may also be costs for the minority shareholders,

considering that the controlling owners could attempt to expropriate value from them. In a

cross-country analysis, Faccio and Lang (2002) show that Italy has one of the lowest

percentages of firms with dispersed ownership in Europe. Meanwhile, in a sample of 450 UK

companies, Brammer and Pavelin (2006) find that firms showing dispersed ownership features

are far more likely to disclose voluntary information than other firms.

2.4.6 Audit Quality

Based on agency theory, when agency costs are high, firms are likely to use corporate

governance mechanisms and voluntary disclosure to diminish those costs. External audit firms

can have a marked effect on the degree of voluntary information disclosed in company

annual reports (Barako, Hancock, & Izan, 2006). Financial statements audited by a

reputable independent auditor may also augment the level of investor confidence, both in the

firm and in its annual report. Frankel, Johnson, and Nelson (2002) show that the monitoring

offered by an independent and high-quality external auditor reduces the management’s

ability to engage in earnings management activities. In a comparative study of Dutch and UK

companies, Camfferman and Cooke (2002) find a positive association in the UK between

voluntary disclosure and those firms audited by big auditing firms.

2.6 Altman's Z-Score and Financial Distress

Altman’s (1968 and 1993) Z-score model may be used to predict the probability that a firm will

go into bankruptcy in the near future . Altman’s (1968 and 1993)Z-values have been

continuously adopted by practitioners and researchers. Dichev (1998) applies Altman’s Z-

values as a proxy for firm distress risk in his study on the size and book-to-market effects. Leary

and Roberts (2005) use Altman’s Z-values as proxies for adjustment costs in debt issues,

in testing the role of adjustment costs in explaining changes in the capital structure.

Holder et al. (2000) measure financial distress by Altman’s model.

Balasundaram (2009) applies Altman Z-model in Sri Lanka and predicts corporate failures in

manufacturing firms listed in Colombo Stock Exchange. . Begley et al. (1996) examine the

Altman Z-model and conclude that the model performs better in the 1980s than in the

1990s. Gerantoni et al.(2009) investigate whether Z-score models can predict bankruptcies for a

period up to three years earlier, and show that Altman’s model performs well in predicting

failures. According to Grice and Robert (2001), overall accuracy of Altman Z-model is

significantly higher in the case of manufacturing firms.

The Z-score measure, which has traditionally been used as a proxy of individual risk for the

banking sector (Boydet al., 2006;Laeven and Levine, 2009;Lepetit and Strobel, 2013;Baselga-

Pascualet al., 2015;Chiaramonteet al., 2015;Khanet al., 2017), may be a useful tool when applied

in the insurance sector. The Z-score relates a firm’s capital level to the variability in its return on

assets (ROA), revealing how much variability in returns can be absorbed by capital without the

firm becoming insolvent (Liet al., 2017). The popularity of the Z-score derives from its relative

simplicity and the fact that it can be computed using accounting information alone. In contrast to
market-based risk measures, this indicator is applicable when dealing with an extensive number

of unlisted as well as listed companies(Chiaramonteet al., 2016).

2.7 Theoretical Framework

The following theoretical frame work is derived from the above literature review.

Corporate Governanace
Corporate Governance
Risk Management
(i) Board Size
(ii) Ownership concentration (Z-Score)
(iii) Board Independence
(iv)Audit Committee

left side of the above framework shows the independent variables of the study while the right

side of the framework shows the dependent variables of the study.

2.8 Conclusion

This chapter shows related literature on corporate governance and risk management. Theoretical

background wherein different theory and its relationship with the corporate governance is shown

also these theory are empirically tested to show whether these theories are related with corporate

governance or not.. This section further shows how corporate governance in banking sectors

helps to manage the risk of the sector, empirics have also been shown in this part. Later part of

this section shows the element of corporate Governance and its relationship with risk

management, empirical work shows some support as well as contradiction between the elements

of corporate governance and risk management.

This chapter also shed light on the importance of Altman' Z-score and has also empirically

shown that how able is z-score to predict the soundness of a firm.